Stocks

(The authors are Reuters Breakingviews columnists. The opinions
expressed are their own)

By George Hay and Peter Thal Larsen

LONDON, Sept 9 (Reuters Breakingviews) - Sir John Vickers is
about to drop his bombshell. On Sept. 12, the chairman of
Britain’s Independent Commission on Banking will unveil the
results of a 14-month probe into stability and competition in
the UK sector. The ICB’s mission is to solve what finance
minister George Osborne has dubbed the “British dilemma”: how to
maintain a large financial industry while protecting taxpayers
from future bailouts.

The ICB is expected to recommend that lenders “ring-fence”
those operations deemed vital to support the economy in separate
subsidiaries. The government looks set to follow that advice.
However, the future shape of UK banking will depend on how the
ICB answers four key questions.

1. How wide?

The first conundrum is which assets should be allowed inside
the ring-fenced subsidiary. A “narrow” fence would be limited to
retail deposits and mortgages. A “wide” option would include
small business lending, and possibly large corporate deposits
and loans. Only investment banking activities are certain to be
left out.

Splitting out safe deposits will raise the risk profile of
the businesses on the other side of the ring-fence. This, in
turn, will increase banks’ funding costs and squeeze earnings.
But where the line is drawn affects banks in different ways.

Barclays (BARC.L) and Royal Bank of Scotland (RBS.L), which
have large investment banking operations, would probably fare
better with a narrow ring-fence: it is the option that will do
least to disrupt the funding of their remaining businesses. The
narrow scenario would knock 13 percent off RBS’s 2013 pretax
profit, according to Credit Suisse. But if the ring-fence was
wider, the lender’s pretax profit would drop 27 percent.

By contrast, UK-focused Lloyds Banking Group (LLOY.L) would
be better off with the wider option. That would enable it to put
up to three-quarters of its assets in the safer ring-fenced
subsidiary. A wide ring-fence would reduce Lloyds’ 2013 pretax
profit by just 4 percent, Credit Suisse calculates. But if the
ICB chooses the narrow option, the bank’s earnings would fall by
quarter.

2. How high?

Another question is how strictly ring-fenced assets are
separated from the rest of the business. Should a ring-fenced
bank be allowed to pass surplus capital to the rest of the
organisation? Should it be able to provide funding to
non-ringfenced assets? Banks would prefer the fence to be low,
allowing capital and liquidity to flow to the rest of the bank.
But the point of the exercise is to protect the flow of credit
to the economy even if non ring-fenced businesses get into
trouble. This suggests the IBC will limit the ring-fenced
subsidiary’s ability to interact with the rest of the bank --
adding to the cost of reform.

3. How flexible?

Then there is the issue of the small print. For example:
where is the dividing line between a small business customer,
whose assets may be inside the ring-fence, and a large
corporation, which may be excluded? And how should banks
distinguish between retail customers, and ultra-wealthy clients
which resemble institutional investors? The ICB is likely to
leave it to the authorities to sort out these details, creating
another opportunity for bank lobbying to chisel away at its
prescriptions.

4. When?

Regardless of how the ICB answers the first three questions,
ring-fencing will be complex and costly. Vickers could sugar the
pill by recommending that implementation could be delayed, to
say, 2015. With a reasonable phase-in period (perhaps aligned
with the timetable for Basel III bank capital rules) that could
push full compliance to 2018-19.

It’s easy to see why banks and the government might favour a
long implementation. Markets are volatile and the economy is
weak. According to Ernst & Young’s ITEM club, the impact of
ring-fencing could knock 0.3 percent off UK GDP. That is
significant when UK GDP may only grow by 1.1 percent in 2011.

However, delay may not help that much. After all, most
lenders are striving to hit Basel III standards well ahead of
the official schedule. If ring-fencing renders some aspects of
their business models obsolete, it’s hard to see investors
giving them much credit for negotiating a few years’ stay of
execution. Banks would be better off accepting the new reality,
and start working out how best to adapt to it.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

Get Breakingviews alerts directly to your inbox three times
a day. To sign up click here:
www.breakingviews.com/TOPNewsSubscription

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

-- For previous columns by the authors, Reuters customers can
-- For previous columns by the authors, Reuters customers can
click on [HAY/] and [LARSEN/]

(C) Reuters 2011 All rights reserved. Republication or redistribution of
Reuters content, including by caching, framing, or similar means, is
expressly prohibited without the prior written consent of Reuters. Reuters
and the Reuters sphere logo are registered trademarks and trademarks of
the Reuters group of companies around the world.